Highlighting Court Cases Impacting Accounting and Tax Compliance
Case determinations impacting the cannabis industry, including challenges to § 280E and the non-deductibility of expenses.
Highlighting Court Cases Impacting Accounting and Tax Compliance for the Cannabis Industry
Disclaimer: The information contained within this document is highly summarized and should not be construed to be complete or used as a sole source of information, nor should it be relied upon, interpreted, or used as any type of authority, advice, or opinion, in any form. The information is applicable as of the original publish date. All citations related to federal income tax codes and regulations within this document are abbreviated for readability purposes only, however are intended to be clear as to the sections and subparagraphs referenced. The content is provided for general purposes only; all information within should be independently verified. The use of this disclaimer does not affect the degree of care given to the summary information written or sources referenced. Please contact your tax advisor to discuss any topics pertaining to your business or situation. Originally published June 22, 2022.
Highlighting Tax Court Cases and other Determinations Impacting Accounting and Tax Compliance for the Cannabis Industry
At the time of this writing, one of the most recent Tax Court decisions with cannabis industry issues in focus was Lord v. Commissioner of Internal Revenue (March 2022). The highlights in this decision are summarized near the end of this article. Particularly interesting to the case, is the attention to generally accepted accounting principles (GAAP) vs. tax based accounting methods, related to depreciation allowable within a cost of goods sold adjustment. The Court’s judgment here may be notable to some, in regards to more complex views and potential broader implications of GAAP vs. tax basis differences.
Before getting there however, (and likely diving into more detail of some of the GAAP vs. tax basis differences in a later publication), it is important to summarize many of the historical Court determinations that have helped shape accounting and tax compliance applications for cannabis operators.
This summary is by no means complete or inclusive of all relevant information related to the cases highlighted below. Several key informational items are not included. The complete case text, as well as information on relevant former or pending appeals, should be sought in order to provide a more comprehensive perspective. Not all applicable cases or decisions are covered. This summary is general and for public view, and is not intended to be used or relied upon as advice for any purpose.
All cases are summarized, with titles and citations incomplete for readability purposes only. Dates referenced in the subtitles are the filing dates. Code sections (§) referred to are that of the Internal Revenue Code under Title 26 of the U.S. Code, unless otherwise noted. External links are provided for convenience only, and we have no control over the content published, nor any affiliation with the publisher. References to ‘Tax Court’ or ‘Court’, are general in nature.
Sundel vs. Commissioner, February 1998
While the Sundel case relates to an illegitimate and illegal marijuana operation in which Sundel and his partner were found to have distributed 25,000 pounds of marijuana, several foundational issues that come into play in later cases were addressed. Notable points include:
Expense deductions were disallowed pursuant to IRC § 280E. The IRS calculated the cost of goods sold (COGS) as an adjustment to gross receipts, which the Court accepted over Sundel’s own calculation. The methodology of the calculation, with computation of taxable income based on gross profit, or gross receipts less COGS, is still the basis cannabis operators calculate their taxable income on today. It was determined that Sundel had at least $3,158,000 of unreported income from the sale of marijuana.
Self-employment tax was applicable. The Court found that the taxable income derived from the illegal marijuana sales was subject to self-employment taxes.
Fraudulent activity for non-reporting was upheld. While Sundel was criminally convicted outside of Tax Court (TC), the TC found that the petitioner had acted fraudulently by not reporting the income from the marijuana sales on his tax return, along with other matters. Additional penalties were assessed, and the assessment and collection statute of limitation dates were deemed inapplicable because of the presence of fraud.
United States v. Cannabis Cultivators Club; United States v. Oakland Cannabis Buyers Cooperative, May 1998 - May 2001
Two separate cases, both focused on medical cannabis as a controlled substance under the Controlled Substances Act (CSA), and helped establish later precedent for challenges to § 280E for state legalized medical cannabis operators.
In U.S. v. Oakland Cannabis Buyers Cooperative, the United States sued the Cooperative to stop distributing medical marijuana under the California Compassionate Use Act of 1996 (CCUA). The Cooperative challenged the prohibition of medical cannabis as a medical necessity under the CSA. The case was ultimately challenged at the Supreme Court.
IRC § 280E prohibits deductions and credits for businesses trafficking Schedule I or Schedule II substances, as included under the Controlled Substances Act, § 812. Here, marijuana is classified as a Schedule I substance. Per the CSA definitions, Schedule I substances include those with no currently accepted medical use, having a high potential for abuse, and with a lack of accepted safety for use. Schedule II substances include those that may have a medical purpose, but may lead to severe psychological or physical dependence.
Schedule III substances, for which § 280E is not generally applicable, includes those substances with a recognized medical use, but may also lead to moderate or low physical dependence or high psychological dependence. Schedule IV is less restrictive, applying to those substances with limited dependence.
In both cases, including related appeals, the Courts upheld that medical marijuana was a Schedule I controlled substance. It was also generally noted that a change in law from Congress would be necessary to remove marijuana from Schedule I. Over twenty years later, and with general medical use and acceptance having expanded greatly, Court positions have generally so far remained similar.
Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, May 2007; Commonly known as the CHAMP case.
CHAMP was a groundbreaking case. Here, the focus was on § 280E applicability to non-cannabis business activities. In the determination, the Tax Court allowed ordinary and necessary expense deductions for CHAMP’s non-cannabis business related activity. However, several additional points are notable:
CHAMP’s primary activity was found to be caregiving, or social and community based activities. Activities included yoga, support groups specified by medical condition, counseling services, speakers, hot meals, field trips, computer access, and the provision of hygiene supplies. The organization’s intention was for charitable purposes, with the Executive Director having 13 years of health services experience. Members paid a membership fee, which included a specific amount of medical marijuana. Members, many of whom suffered from AIDS, were taught how to use the medical marijuana in order to alleviate their medical symptoms, as one of the organization’s several other activities.
CHAMP had books and records sufficient enough to support the separate activities, and their testimony was found to be credible in order to support social caregiving as the primary activity. Among other items, the organization showed that both the majority of its employees and floor space were dedicated to caregiving services only. Medical marijuana provision and use only involved a limited number of employees and took place in a designated area that was approximately 10% of the entire space used.
The Court held that § 280E did not preclude CHAMP from deducting expenses attributable to a trade or business other than that of illegal trafficking in controlled substances simply because they were also involved in trafficking controlled substances.
Expenses were apportioned, and CHAMP was able to take ordinary and necessary expense deductions for its non-marijuana business activity.
It is important to note that while the CHAMP case is often referred to for provisioning centers engaging in non-cannabis activity, such as general retail sales, the details of the CHAMP case indicated cannabis provisioning was a secondary business activity, not primary. The next case challenges similar concepts, however was found to be unfavorable for the cannabis retailer.
Olive v. Commissioner of Internal Revenue, 2012; Appealed and upheld July 2015
The Olive case was another earlier challenge focusing on the limitation to deductibility of expenses pursuant to § 280E. Olive operated an establishment called Vapor Room Herbal Center, where patrons could purchase and consume medical cannabis, as well as participate in community activities throughout the facility, including the availability of games, books, and art supplies for general use, and activities such as yoga, movies, and massage therapy. Complimentary food and beverages were also provided. All patrons and staff were permitted under California law to receive and consume medical marijuana. Additional notable points included:
Olive referenced the CHAMP determination in order to attempt to establish the Vapor Room as having two separate business activities, one related to cannabis provision, and the other related to community activities. Unlike in the CHAMP case however, the Court found the Vapor Room’s activities to be one business activity, with the community activities provided as incidental to the primary business of medical marijuana sales and consumption.
The Vapor Room was unable to establish separate activities, including through its books and records, which were also not found to be credible in establishing additional COGS. The company had one source of revenue, which was direct medical cannabis sales. The testimony on behalf of Olive, including from his accountant to substantiate additional COGS deductions, was found by the Court to be rehearsed and unreliable. Accuracy related penalties were also upheld, along with mention of the taxpayer’s choice to not keep adequate books and records, in conscious disregard of rules and regulations.
When filing his tax return, Olive included the Vapor Room’s principal business as “Retail Sales”, and that the product was “Herbal.” Additionally, it was found that he regularly removed cash from the cash register to pay for personal travel, and accounted for the withdrawals so that employees would not know how much money he was taking from the business.
Beck v. Commissioner, August 2015
The Beck case involved two medical marijuana dispensaries in California, operating under the name of Alternative Herbal Health Services. Here Beck, the owner, challenged the deductibility of expenses on his personal return, as well as a loss deduction under § 165. Notable details include:
In 2007, prior to the IRS investigation, one of the dispensaries was subject to a DEA raid. The search warrant was authorized both federally and through the Los Angeles Superior Court. During the raid, officials seized the dispensary’s marijuana products, plants, and cash. Beck claimed the value of the products seized within his cost of goods sold on his tax return, and also sought a loss pursuant to § 165, which generally allows a deduction for losses related to property disposition within a trade or business. The Tax Court denied both the inclusion of the seized products within cost of goods sold, as well as the loss deduction.
Beck did not maintain sufficient records to substantiate the value of the seized products. He was found to have routinely and purposefully destroyed business records from the dispensary operations instead. The Court was unable to substantiate the value of the deduction being claimed due to lack of records, and indicated this was reason enough to disallow a deduction. (All businesses are required to keep records in order to substantiate deductions.) Furthermore, because the products were confiscated, not sold, the Court held that the value was not able to be included in COGS. The loss deduction under § 165 was disallowed also, pursuant to § 280E.
The taxpayer was also found to be liable for accuracy related penalties, with the Court citing their negligence in not having kept business records.
When considering marijuana products regulated by State programs, and the potential need to ‘destroy’ non-compliant products, the Beck case may provide key information related to how the cost basis of destroyed, not sold, products might be viewed from the Court’s perspective.
Canna Care, Inc. v. Commissioner, 2015; Appealed and upheld July 2017
The Canna Care, Inc. case involved a medical marijuana dispensary in California, which incorporated as a mutual benefit corporation under the State’s laws. Mutual benefit corporations are intended to operate similar to not-for-profit entities, however may generally not be exempt for federal income tax purposes. The petitioner however stated that he had opened the marijuana dispensary to solve his family’s financial hardships. The case again focused on the applicability of § 280E.
In addition to dispensing medical marijuana in accordance with California law, the dispensary also sold books, t-shirts, and hats, as well as offered community events and educational, legal, and religious information to its patrons. It was found that no employees had any substantial past healthcare experience.
The Court held that Canna Care, Inc. was engaged in for-profit activities. Additionally, the Court also held that Canna Care’s ancillary sales and activities were incidental to its purpose of selling medical marijuana, and were not considered a separate business activity. The company was found to be trafficking marijuana, and consequently the Court upheld that § 280E disallowed it from taking expense deductions.
The decision was later appealed, however with different arguments. These arguments included that § 280E violates the excessive fines clause in the Eighth Amendment, § 280E does not preclude state and local tax deductions, and § 208E does not preclude an operating loss carryover deduction. Since none of these arguments were raised in the initial case, the Court declined to consider them.
Alpenglow Botanicals, LLC v. United States, Various 2016 - 2019
Originally dismissed in 2016, the Alpenglow Botanicals series of attempted complaints, hearings, and denials, including before the Supreme Court, sought to challenge the IRS’s authority to administratively determine the company was trafficking a controlled substance, and not allowed deductions pursuant to § 280E. The company also claimed that Congress exceeded its power under the Sixteenth Amendment by passing § 280E, as well as that IRS proceedings violated its Fifth and Eighth Amendment rights. Operating under Colorado law, Alpenglow also sought monetary refund relief related to the IRS’s decision to deny deductions to income.
The Court analyzed the claims of violation of Alpenglow’s rights under the Fifth and Eighth Amendments, among other information, with the decision in the IRS’s favor.
The Green Solution Retail, Inc. v. United States, May 2017, with various subsequent cases and appeals.
The Green Solution Retail, Inc. case challenged the IRS’s authority to investigate the business’s records. A Colorado dispensary, Green Solution sued the IRS, seeking to enjoin it from investigating whether the company trafficked a controlled substance in violation of federal law, and therefore disqualifying it from taking business deductions, due to § 280E. The Green Solution had several dispensary locations across Colorado, however claimed that if the IRS were allowed to continue its investigation and deny business expense deductions, the company would be deprived of income, suffer a penalty that would effectively be a forfeiture of all of its income and capital, and also violate its Fifth Amendment rights.
The argument was decided on appeal, with the first petition being dismissed. The Appeals Court upheld that restraining any such assessment by the IRS was barred. Subsequent attempts at appeal, including with other Colorado based dispensaries, as well as with a petition to the Supreme Court, have not been successful in Green Solution's favor.
Harborside Health Center, November 2018; Appealed and upheld April 2021
Officially known as Patients Mutual Assistance Collective Corporation v. Commissioner of Internal Revenue, the original case text acknowledges that Patients Mutual, doing business as Harborside Health Center, may have been one of the largest marijuana dispensaries in the United States. Here, the case sought to challenge the calculation of cost of goods sold for the dispensary, referring to both § 471 and § 263A applicability. A landmark case, the decision upheld the application of separate inventory valuation rules for resellers and producers, inline with the language within the regulations under § 471.
Until a few years before the case, and including the return years under investigation, a common practice to mitigate § 280E was to apply inventory rules under § 263A, or those for manufacturers under § 1.471-11. These rules generally allow for both direct and indirect production costs to be capitalized to inventory. Conversely, retailers generally must follow § 1.471-3(b), which, in general, is much less inclusive of allowable costs. The case also challenged the use of § 263A, which would have allowed additional costs to be capitalized, outside of what is specifically allowed for under § 471.
The Court disallowed costs traditionally only afforded to producers, or manufacturers, and held that Harborside was a reseller (retailer). Harborside on the other hand claimed it was also a producer. The Court found that while Harborside did engage in activities to sell clones to growers, with the expectation that the growers would then sell the finished flower back to Harborside, Harborside did not have sufficient control over the growing process, nor was it guaranteed that the growers would or had to sell back to Harborside. Harborside was therefore found to be a reseller, and denied the additional costs it sought to have included in its inventory and COGS calculations.
The case examined in detail the meaning of various topics, including the definition of producers and manufacturers. The Court agreed that Harborside could take its direct costs as a reseller of the inventory into its inventory valuation under § 471. It also noted that purchasing, handling, and storage costs are categorized under § 263A regulations, which it previously has held is not allowable. In early 2015, the IRS released a memo generally stating that additional costs under § 263A were not allowable for cannabis businesses when calculating their inventory value. The returns being audited were prior to this memo, and also prior to the Olive case decision under appeal.
In addition to marijuana sales activity, Harborside also argued that it had four separate business activities, including non-marijuana sales, therapeutic services, and brand development, with these other three not involving the sale of cannabis and not subject to § 280E. The Court examined each claim separately, and found none to be a separate trade or business, but incidental to the marijuana sales. Marijuana and marijuana products accounted for approximately 98.7% - 99.5% of the business’s total revenue during the years examined.
Harborside argued that its branding activity was a separate trade or business, operating at a loss and part of a unified business enterprise. The same entity, management, capital structure, employees, and facilities were used for the brand development activity. The Court found that these and other aspects supported the conclusion of the brand development as a non-separate business activity, contrary to Harborside’s position.
Also notable to the case, is that Harborside won a later judgment against the accuracy related penalties that had been imposed on it. The company was determined by the Court to have kept detailed records, and demonstrated reasonable application of the rules, during a time when no clear authority or guidance existed at the time under audit. Additionally, Harborside subsequently changed its method of accounting as guidance was released, and prior to IRS proceedings.
Current best practices in inventory valuation and related COGS calculations rely heavily on the Harborside case. Harborside appealed the decision, and it was upheld in 2021.
Alternative Health Care Advocates v. Commissioner, December 2018
Not unlike the Harborside case, the Alternative Health Care Advocates (AHCA) case may also be more distinguishable than others. Here, the decision impacts business structuring, including related party and service organization transactions. § 280E is also challenged again. According to the circumstances of the case, the results were punitive in nature to AHCA.
The case involved a cannabis retailer, whose ownership operated a separate ‘management’ services company. The businesses interacted with each other with the service entity providing staffing, advertising, rent payments, and other expenditures generally non-deductible under § 280E. The retail entity paid the management entity for these services. The expenses were not deducted by the retail entity, which correctly applied § 280E. However, the management services company deducted its related expenses, assuming § 280E was not applicable to this separate entity.
Additional notable facts included that the management entity provided no services to unrelated entities, nor did it generate revenue outside of supporting the cannabis entity. The company owners were also determined to have been non-compliant with their own reporting and filing obligations.
The Court determined the separate management company’s only purpose was to support the cannabis retailer, and thereby it too was subject to § 280E. Because of the separate structures, expenses were disallowed twice, with the case acknowledging this to be a tax consequence of the structure AHCA chose to employ.
The Court also agreed with the assessment of accuracy, failure to file, and failure to pay penalties against the owners of AHCA. Noting the above as only in part contributing to unreported income by the taxpayers, the owners also had not reported their interests in the companies on their tax returns, including one owner not having filed their required returns at all prior to the original IRS deficiency notice.
Northern California Small Business Assistants, Inc. v. Commissioner, October 2019
This case may be most well known for the context and opinions by more than one judge who partially dissented from the Court’s overall decision. Here, Northern California Small Business Assistants (NCSBA), a medical marijuana dispensary operator, claimed multiple arguments, including § 280E was unconstitutional under the Eighth Amendment; § 280E only bars deductions under § 162 and not other deductions within other sections under the Internal Revenue Code; and that § 280E does not apply to marijuana businesses legally operating under State law.
Additionally, state and local tax deductions under § 164 and depreciation deductions under § 167 were also addressed, with the Court determining these to also be non-allowable pursuant to § 280E.
The Court held that NCSBA’s arguments were not sufficient, and that Congress, rather than the Court, was the proper body to address the grievances against § 280E. While the overall opinion was unfavorable to the cannabis retailer, notable to the case is further context from multiple partially dissenting judges, related to whether § 280E violates the Eighth Amendment. Summarizing one of the dissenter’s opinions:
It has historically been held (and continues to be held against future similar arguments), that Congress has the authority to tax incomes under the Sixteenth Amendment, and the legislative grace to limit deductions. There are many cases in tax law where deductions are specifically limited, such as § 162(f), which generally disallows the deduction of penalties related to violations of law or the failure to pay taxes. The judge however, after explaining additional concepts and citing cases related to the calculation of “income” and “gain”, believed that wholesale disallowance of all deductions does not result in taxable income for what the Sixteenth Amendment allows and § 280E to be unconstitutional under the Eighth Amendment.*
The dissenting judge also explained that if a taxpayer (presumably non-cannabis) were to challenge a deduction disallowance under a different amendment, such a broad interpretation and dismissal of deductions being a matter of legislative grace, would miss the mark. The judge also cited past decisions upholding limiting the disallowance of a deduction based on invidious discrimination, and went on to describe how the effects of § 280E could be characterized as an excessive penalty, and included reference to how past cases involving cannabis businesses may have fallen short in analysis of this consideration. Further, it was also noted that government revenues from penalties related to disallowed activities, generally, are for the purpose of covering costs related to enforcement.
Other judges also agreed and partially dissented, with additional explanation of how § 280E may be punitive and requires further analysis under the Eighth Amendment.
*The same judge later opined in a 2021 Tax Court Memorandum that § 280E does not violate the Eighth Amendment. See Today’s Health Care II LLC v. Commissioner. The judge cited the NCSBA case and stated that the decision would not depart from that of the NCSBA decision.
Standing Akimbo v. United States, Multiple from April 2020 - September 2021
Standing Akimbo is a medical cannabis dispensary in Colorado. The IRS requested business records from the owners during investigation proceedings. Among other items, the IRS requested METRC information, including gross sales reports, transfer reports, harvest reports, and monthly inventory reports. The taxpayers refused to provide complete information sufficient for the IRS to verify the accuracy of their tax returns, claiming protection from self-incrimination of potential federal drug related crimes and abusive processes.
The Court upheld the IRS’s right to summon the information as legitimate for its investigatory purposes, and non-abusive. It was noted that the IRS had not referred the case for criminal prosecution.
Standing Akimbo continued to challenge their argument, and ultimately petitioned the Supreme Court. The Supreme Court denied their petition for writ of certiorari. However, Justice Thomas gave a landmark statement in respect of the denial. Notably, he referred to many contradictions among the federal government’s stance on enforcing federal marijuana prohibition, including Congress’s recent prohibition of the Department of Justice spending funds to prevent state implemented medical marijuana laws. Justice Thomas ended his statement with “A prohibition on intrastate use or cultivation of marijuana may no longer be necessary or proper to support the Federal Government's piecemeal approach.”
San Jose Wellness v. Commissioner, February 2021
San Jose Wellness operated a medical cannabis dispensary in California. This case again challenged § 280E with generally similar arguments that had already been addressed in previous cases. Specifically, the disallowances of depreciation deductions under § 167, and charitable contribution deductions under § 170, due to § 280E, were challenged. The Court disagreed with the challenges, and also sustained accuracy related penalties that had been assessed on the business.
Lord v. Commissioner, March 2022
The Lord case is another with notable points of interest, with the Court’s determination impacting GAAP vs. tax basis methods of accounting. Lord operated a business in Colorado licensed to cultivate, process, and distribute medical marijuana. The Court upheld the IRS’s position to change the taxpayer’s method of accounting, requiring GAAP based depreciation and useful life when calculating the amount attributable to production assets and able to be included in its inventory value. Depreciation and bonus depreciation calculated under § 167 and § 168 were disallowed as deductions, and were found to not be allowable within cost of goods with § 280E in place.
Other notable highlights and potential impacts of the Lord case include:
While previous cases have attempted to challenge § 280E and its applicability to state licensed cannabis businesses, the Lord case examined the detail within § 1.471-2 and § 1.471-11, regulations related to inventory valuation rules and valuation rules specific to manufacturers and producers. The Court agreed with the IRS that the appropriate method of accounting for the taxpayer to clearly reflect income related to the production assets was based on generally accepted accounting principles (GAAP), outside of the tax code. The language within the income tax regulations supports this determination.
Most cannabis businesses follow a tax based method of accounting. GAAP rules can be significantly different in some cases, including related not only to asset depreciation and amortization, but potentially lease accounting, revenue recognition related to certain contracts or licensing agreements, intangible asset treatment, and other areas. The decision could potentially lead to the need to consider other GAAP vs. tax basis differences. Should GAAP move to further converge with International Financial Accounting Standards, inventory accounting treatment could be affected in other additional ways.
The Lord case wraps up the cases covered by this publication, based on information available at the time of writing. The IRS continues to employ a strict view towards enforcement of § 280E for state regulated cannabis and medical cannabis businesses. In May 2022, the Taxpayer Advocate Service released a blog article with additional acknowledgement towards the industry. Check out their post here.
Written by Kareyna L. Miller, CPA
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